What's The Deal Dirk?

Student Q&A's with Dirk

Hi Dirk, First of all, cool web page. I have always been a little confused about the concepts of the "income effect" and "substitution effect". Could you explain these concepts in a simple way? Econ student from Dominican Republic.

This question asked by Anonymous

I'm glad you found my webpage. The income effect refers to the purchasing power of your income. This means that when prices changes -- but your income does not -- your income will be able to buy more if prices fall, or less if prices rise. The income effect is quite small if a candy bar changes price from 75 cents to $1.00 because the price has only risen by a quarter. But if a set of four tires for your car rises from $750 to $1,000 the increase in price will require you to spend an extra $250 that you don't have. Therefore, the income effect is much more pronounced for the big purchases we make. The subsititution effect is important for all purchases, big and small. When the price of one item changes -- say Pepsi rises to $2/liter and Coca-cola stays at $1.50 -- some people who like Pepsi will switch (or substitute) to Coca-cola. The easiest way to remember this is to think of the subsititution effect as involving relative price changes among similar products while the income effect measures how much purchasing power you have. I hope this helps.